Africa’s capital markets are reputed to be challenging for foreign institutions to navigate. Despite this, the region could be the next frontier for ESG (environmental, social, governance) investing.
African economies – along with many other frontier and emerging markets – suffered from heavy foreign investor outflows during the initial stages of COVID-19. Despite recovering somewhat, the recent flurry of macro headwinds is limiting foreign investment into Sub-Saharan Africa (SSA).
In many of the smaller SSA countries, the local equity markets are thinly traded and broadly un-tapped – although this could potentially give forward-looking international investors first mover advantage and the ability to identify market mispricing opportunities.
While African fixed income has historically been traded by local investors such as pension funds and insurance companies, global institutions are starting to take an interest. However, many are sitting on the side-lines owing to concerns about inflation and the impact which interest rate hikes could have on the region.
Nonetheless, investing into Africa is not always a straightforward undertaking. For some of the largest institutions, the risk-reward benefits of investing into the smaller, more illiquid African economies do not make sense – primarily because their sizeable capital allocations risk saturating the local market.
There are also a number of logistical and operational challenges which investors need to be cognisant of when building up exposures in the region, not least of which is the propensity for certain markets to impose currency controls and FX restrictions.
Take Nigeria, where thin FX liquidity is a persistent challenge for foreign investors repatriating their funds. In this market the mandatory conditions of FX allocation now include the bundling of spot and forward deals. Intermediaries and foreign investors whose risk management frameworks do not allow FX forward deals in Nigeria have limited access to repatriation funds in the market. This is a risk which still continues today. Additionally, investors have occasionally found themselves being blind-sided by the authorities making sudden changes to tax rules or regulation – often with little forewarning.
All of these risks need to be carefully considered by investors in Africa.
Fuelled by an assortment of investor demand and regulatory pressure, ESG assets under management (AuM) have skyrocketed - with the Global Sustainable Investment Alliance putting AuM at $35 trillion in 2020, up from $30.6 trillion in 2018, and $22.8 trillion in 2016.1
1 Investment Week (July 21, 2021) ESG assets on track to exceed $50 trn by 2025
As capital continues to accumulate in ESG funds, Africa is likely to be a major beneficiary – especially as many countries in the region have strengthened their sustainable bond markets.
For instance, Ghana announced in 2021 that it was considering issuing $2 billion worth of green and social bonds with proceeds being deployed to fund development programmes.2 Other African markets are also following in the footsteps of Europe and parts of Asia and North America by forcing listed companies to disclose information about their ESG policies.
While African markets are giving serious thought to ESG issues, governance continues to be an Achilles heel in certain countries. In the absence of strong governance, companies are at risk of not meeting their ‘E’ and ‘S’ objectives. If ESG in African markets is to thrive, then governance is something which needs to be urgently improved upon in many countries.
In addition, globally there are potential flaws in the scoring systems at ESG analytics companies. This is because some of the methodologies used to score companies and markets on ESG are not harmonised - frequently leading to anomalous results. It is therefore not unheard of for competing analytics’ firms to award contradictory ratings or scores to identical companies and markets. If the momentum behind ESG investing is to keep growing, these data deficiencies need fixing.
2 Bloomberg (July 5, 2021) Ghana mulls Africa’s first social bonds with $2 billion sale
Clients are looking to rationalise their operations, especially in complex markets such as Africa. This is because engaging with multiple agent banks in the same region creates challenges for investors and intermediaries, as they will need to oversee a plethora of due diligence processes.
Moreover, clients will also receive information from agent banks in a number of different formats. Notwithstanding the cost implications, these set-ups increase the likelihood of errors and mistakes at the client level. In response, more banks and brokers are looking to simplify their agent bank relationships by consolidating the number of sub-custodians they use and appointing vendors on a regional – as opposed to an individual market – basis.
So what are the advantages of this streamlined approach? By leveraging a global provider operating out of a regional hub, clients only need to perform due diligence on one vendor, instead of visiting multiple agent banks in different markets.
Other benefits to the client include having a simplified settlement instruction process; standardised reporting and consolidated billing – all of which facilitate cost savings, efficiencies and simplicity. Through a more entrenched relationship with a single agent bank, clients will be able to forge closer strategic partnerships thereby supporting growth and encouraging innovation.
African markets show enormous potential as investors increasingly chase ESG opportunities. Despite this, there are challenges. Many frontier markets – including those in Africa – do pose risks (i.e. FX risk) and these need to be taken into account. In order to navigate African markets, it is vital clients rethink how they manage their sub-custody networks. Many are already doing so, evidenced by the tacit shift towards consolidation over the last few years.
This article is based on themes discussed during a panel discussion at The Network Forum Africa Meeting 2022.
